With a background in economics and public policy, I've covered domestic and international energy issues since 1998. I'm the editor-in-chief for Public Utilities Fortnightly, which is a paid subscription-based magazine that was established in 1929. My column, which also appears in the CSMonitor, has twice been named Best Online Column by two different media organizations. Twitter: @Ken_Silverstein. Email: ken@silversteineditorial.com

Utility Mergers Rising but Picking Partners is Tricky

Electric utilities are looking to generate steam through mergers, which some analysts are saying will help them improve efficiencies and increase productivity. The most recent deal making its way through the regulatory maze is that of NRG Energy and GenOn Energy, which is a valued at $4.2 billion.

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That proposal is part of a broader trend — one where power companies are uniting in an effort to increase their leverage in the market. As those synergies start to escalate, the hope is that the savings would flow back to both ratepayers and shareholders, who benefit in the form of greater dividends. At the same time, any combined entity would be better positioned to invest in new technologies so that it could comply with tougher federal and state environmental regs.

“The quarter, we saw the highest level of deal activity of transactions worth over $50 million since the third quarter of 2011, as companies look to scale operations to drive revenue,” says Jeremy Fago, U.S. power and utilities valuations leader for PriceWaterhouseCoopers (PwC.) “Consistent with our earlier reports, we continue to see increased generation asset activity, both fossil and renewable.”

In the third quarter of 2012, six transactions have been announced. The biggest, NRG and GenOn, is following in the footsteps of other major deals: FirstEnergy Corporation’s purchase of Allegheny Energy in 2010 for about $4.7 billion and Duke Energy’s marriage with Progress Energy in 2012, a deal valued at about $25 billion that became a national spectacle soon after it finalized. Exelon, meantime, bought Constellation for $8 billion in 2012 after getting rebuffed by NRG in 2008 and by New Jersey regulators when it tried to merge with PSEG in 2006.

Utilities, of course, want to drive down the cost of everything from paperclips to borrowing. To that end, the ultimate effect on credit quality may influence the decision-making process. The goal, says Standard & Poor’s, is to return the sector to “A” ratings category. Along those lines, larger and financially stronger companies may be more capable of managing the regulatory risks.

As for the NRG and GenOn proposal, it is in the merchant energy space that is unregulated and where the electric power plants sell their product at market rates. They are using modern forms of generation that are not only more efficient but also cleaner than the older units. High demand equates to better profits, although cheap natural gas prices dent their bottom lines.

PwC says that it expects to see continuing activity in this realm because environmental pressures will only heighten. It also says that many of the unregulated power generators will need to broaden their fuel options, meaning they will look for other participants not just in the natural gas area but also in the wind, solar and hydro sectors.

“We’re seeing an uptick in renewable transactions as key incentives are nearing expiration and a few key players look for opportunities to acquire solar and wind assets that are near commercial operation,” says Rob McCeneny, also a power and utilities partner at PwC.

To be clear, there’s a difference between a company cherry picking assets from another company because it may complement its current offerings and two enterprises that merge their entire operations. The former had been the trend until a few years ago. Now, with the economic outlook considered rosier, utilities are about to resume their planned capital expenditure programs — generation and transmission projects — to cope with the expected future increase in demand.

Some analysts have thus concluded that the time is right to come together. But are those mergers good for investors and consumers?

Bill Kemp of Black & Veatch has tried to answer the questions as to whether those pursuits are paying off. He says that the expected synergies are often exceeded, although that may take three years before they are fully felt. Employees, though, feel the immediate effects, with duplicative positions getting eliminated.

Consumers have generally been protected from any escalating rates by their state regulators. Indeed, as the efficiencies mount, utility commissions are ensuring that at least half the savings flow back to customers. Meanwhile, they are insisting that the new utility adopt modern technologies — something that is more feasible given that the combined entity would have better access to capital markets.

And while the company that is getting acquired may receive a premium, the one attempting the purchase could be paying an “excessive” price. “Mergers typically depress stock prices before and after close but stock performance improves 2-3 years after close, as savings are realized,” says Kemp. Within 5 years, though, stock values regress and reflect the average group performance.

Like other industrial sectors, utilities are emerging from hard times and they are trying to prepare for the future. Combining operations may be the most feasible way to increase revenues while also reducing overhead. But companies need to carefully consider their partners so that they can minimize regulatory objections and internal conflicts, all of which may overshadow their primary reasons for joining forces.

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